13 Debt=opportunities and threats Opportunities: leverage effect Threats: Debt may become unsustainable Default results in closing the access to international financial markets And sanctions? The probability of default is linked with the debt ratio, but the debt ratio is not the whole story. Example: Low Income Countries:

18 Outline of the lecture Some facts, with a focus on Foreign Debt Why default? Debt overhang Impact of debt relief Debt is not what it used to be

19 Burdens 1: debt service Debt service, deficit of the current account, decrease of reserves Traditional approach of sustainability: debt repayment is a problem of resources (example: indicator debt service in the short run / reserves) Traditional approach is not consistent with standard economic approach It may explain the paradox of default with low debt ratios

21 Debt overhang (Sachs, Krugman 89) The behaviour of the debtor changes when the debt is more than DM (not likely to be repaid) Before DM : debt service is fixed, the country gains from increasing income After DM : sanctions are imposed, they work as a tax on extra income, so reducing gains.

29 From HIPC to MDRI Multilateral Debt Relief Intiative (G8, Gleneagles, 2005) Cancellation of IMF, WB, AfDB when Completion point of HIPC Intiative is reached (22 countries end August 07) A break with HIPC rationale: if not a problem of debt overhang, what else?

30 Problems with LICs debt Is there a case for total debt cancellation (Jubilee 2000)? Problem of fairness Problem of access to financial markets Problem of further debt sustainability No more loans to LICs? Only grants? Problem of management Development or assistance?

31 Debt relief and Poverty reduction An increase in poverty reducing expenditure? In some cases, debt relief does not provide any additional resources If the country did not formerly repay If the other aid flows are shrinking when debt relief is granted A problem of incentive: Debt relief amounts to providing resources to (previously) bad managed countries. An incentive to default in the future?

32 The impact is difficult to assess Does debt relief result in an increase of resources? In fresh money? Not detrimental to tax collection (Cassimon & Van Campenhout AFD WP, 63, 2008) A positive impact on pro-poor public expenditures (but sometimes weapons!) Mixed impact on investment, growth Mixed impact on poverty And a negative impact on governance?

33 Governance and institutions Source: Idlemouden, 2009

34 Outline of the lecture Some facts, with a focus on Foreign Debt Why default? Debt overhang Impact of debt relief HIPC and MDRI DSF Debt is not what it used to be

35 Main Features of the DSF Debt cancellations but new possibilities: Access the international financial markets (Ghana 2007)? Emerging Donors (BRICs) How to avoid excess borrowing? IMF-IDA debt sustainability framework (DSF)

36 IMF-IDA debt sustainability framework (DSF) Forward-looking analysis 20 year projection period reflects long maturity of LIC debt Based on net present value (NPV) because concessionality is important in LIC financing Baseline scenario (reforms), but also historical trends Standardization (Two alternative scenarios and six bounds tests ) and Comprehensive stress-testing

37 IMF-IDA debt sustainability framework (DSF) (cont d) Debt-burden thresholds defined according to quality of policies and institutions, as measured by the Bank s CPIA The historical average scenario and scenario of less favorable new financing are designed as permanent modifications to baseline. The stress tests analyze temporary shocks to four key macro-economic variables; a combination of these four tests; and a onetime 30% depreciation. Different Thresholds:

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